Applying Derivite Cap Rate for NNN properties - Posted by Steve

import · January 8, 2005, 11:49am

Posted by Loren on February 16, 2005 at 13:05:14:

I believe what you folks have to also consider is the length of the lease and credit quality. Walgreens offers 25 year NNN leases. Many other retailers, like Starbucks I believe, have much shorter leases. I think the longer lease is attractive for many investors, especially those who want to hold onto a low headache property for a long time. The only way for an investor to potentially lose their investment would be for Walgreens, the corporation, to go completely belly up. In this case you can still release the property or sell. This is where the importance of location comes in. In my opinion if an investor is interested in safety above trying to make a killing, taking a snapshot at this moment in time, a Walgreens, with its extremely attractive credit rating, appears to be a pretty good longterm bet.

import · January 8, 2005, 11:49am

Posted by Steve on January 08, 2005 at 12:49:36:

I am a newbie to this site and to investing in Real Estate…I have been following some of the threads, old and new, on here…It has been immensly educational…Please review the following and see if I am on the right track…

I read the excellent article about Derivite Cap Rates by Ray and hopefully understand it by now…Recently, I have also been looking at some NNN CRE. After dabbling in the details of few deals…this is what I found - the credit rating of the tenent largely dictates the financing terms…looks like Walgreens can be financed for mid-to-upper 5’s while Autozone is in the low-to-mid 6’s.

Walgreens have “simple” (as opposed to Derivitive) asking CAP rates of 6.5%…and Autozone are selling at about 7.25%.

My question is this…how do I incorporate this apparent disparity in “financibility”, when comparing NNN properties that are selling at different asking CAP rates.

Here is my attempt to simplify this problem - Property A and Property B - Both of them generate NOI of $100,000. Property A can be financed at 6.5%…Property B can be financed at 5.5%. At an Equity Constant (CoC) of 5% for both properties, I end up at Derivitive CAP rates of 8% and 7.4% respectively. This translates to a price of $1,251,207 and $1,345,585.

I am assuming that the finance rates (or the lender’s CAP rates) reflect the apparent risks associated with each tenent. Does my Equity constant need to be different too? -do they need to be higher for Autozone vs Walgreens? Am I missing anything else here?

I am almost 40 years old and looking for long-term gains and dealing with a very high tax-bracket for the forseeable future. Is NNN with very low cash-flow or zero cash-flow seem right for me?

Looking forward to all your thoughts and comments.

Thanks

import · January 10, 2005, 11:04am

Re: Assessing NNN credit-tenant risk - Posted by ray@lcorn

Posted by ray@lcorn on January 10, 2005 at 12:04:18:

Steve,

If I understand your question, I think you’ve already answered it!

The different finance terms for the respective tenants are reflected in the different derived cap rate solutions. The higher cap results from the less favorable finance terms.

As to the question of risk, credit-tenant deals have to be valued based on a combination of credit strength (rating), location and the suitability of the building for alternative uses. Many investors use only the first criteria… long-term dirt merchants like me will never get away from looking at the real estate with an eye toward the residual value if the tenant goes dark. That’s where I decide if the risk parameters are appropriate… higher risk equals a higher required equity return.

The difference between Walgreen’s and AutoZone is slight, but significant as you found with comparing the finance products available. Walgreens’ current S&P rating is A+/Stable/A-1, and AutoZones’ is BBB+/Stable/A-2. Anything less than BBB- is considered speculative grade (aka “junk bonds”). The reason for the difference in finance terms can be seen in the default rates…

Default Rates
Rated Credit Tenants

Original Rating/Default Rate%*

AAA/.52%
AA/1.31%
A/2.32%
BBB/6.64%
BB/19.52%
B/35.76%
CCC/54.38%

*percentage of defaults by issuers rated by Standard and Poor’s over the past 15 years, based on rating they were initially assigned. Source: Standard and Poor’s Corp/Business Week 2001

As you can see, the default rate more than doubles with each downtick in the original rating. That’s what the lenders see as well.

(BTW, there is a detailed explanation of the S&P rating criteria on their website at www2.standardandpoors.com. You’ll need to register for the site to access the features, but it’s free. Then click on Credit ratings and then Rating definitions. For an explanation of the long-term/short-term ratings, also click on Correlation of Long- and Short-term Ratings.)

As a practical matter I may bump my required return a point or two on the lower credit, but that’s a judgment call for the individual investor. With current price levels of credit tenant properties it is very easy to price yourself right out of the deal because the market is pricing no risk premium other than that reflected in the loan terms.

As to your long-range plan, low/zero-flow deals are very popular for investors in your situation. The advantage is the depreciation deduction, but you have to be careful not to exceed the allowed amount or you’ll wind up with a loss-carry-forward rather than accomplishing the goal of sheltering some portion of other income. Consultation with your tax advisor is in order, which it sounds as if you have a pretty good handle on already.

ray

import · January 13, 2005, 9:59am

Re: Assessing NNN credit-tenant risk - Posted by Randy

Posted by Randy on January 13, 2005 at 10:59:26:

“As to the question of risk, credit-tenant deals have to be valued based on a combination of credit strength (rating), location and the suitability of the building for alternative uses. Many investors use only the first criteria… long-term dirt merchants like me will never get away from looking at the real estate with an eye toward the residual value if the tenant goes dark.”

If you are in a single tenant NNN TIC deal and the tenant does go dark, I don’t see how the investment can do anything except turn turtle.

import · January 13, 2005, 10:08am

Re: Assessing NNN credit-tenant risk - Posted by ray@lcorn

Posted by ray@lcorn on January 13, 2005 at 11:08:36:

Randy,

A TIC is another subject entirely… in addition to real estate valuation issues, the risk parameters extend to similar issues as found with securities. These include the strength of the promoter; the governance structure; the number of owners involved; the finance terms and; perhaps most critical, marketability.

ray

import · January 13, 2005, 2:31pm

Re: Assessing NNN credit-tenant risk - Posted by Steve

Posted by Steve on January 13, 2005 at 15:31:19:

Ray,

Thanks for your excellent and lenghty reply…It has definitely given me some food for thought…

After mulling over the location and re-configurability of properties, I am thinking of the following.

A. That small properties such as Starbucks may be more amenable to multiple-use than Walgreens

B. $1 Million dollar NNN property is less risky than
a $5 Million dollar NNN property…most all else being equal.

C. I believe tha energy crunch in the coming years may drastically alter our community landscape. I think areas that have better pedestrian setting will thrive more than urban sprawls.

With that assumption, a Starbucks in a downtown is better than a Walgreens on a 4-lane highway.

Does these seem like relevant issues to consider before investing in CRE?

Thanks again…

import · January 18, 2005, 1:09pm

Re: Assessing NNN credit-tenant risk - Posted by ray@lcorn

Posted by ray@lcorn on January 18, 2005 at 14:09:47:

Steve,

I agree with A to a point. Walgreens’ building is not so specialized that it cannot be utilized for other businesses, but in my mind location takes precedence over size.

As for B, the size of the deal is not in itself a risk factor, but the proportion the investment holds in the investor’s portfolio does matter. It’s the law of significant digits… $10 is to $100 as $100 is to $1,000. If your all your dollars are in one deal and something goes wrong with it, then you’re 100% exposed. On the other hand, a $5mm investment within a $100mm portfolio does not carry the same risk.

I agree with C, but for different reasons. The energy crisis has been predicted for decades, and may or may not appear, may or may not have the effects predicted, and may or may not be offset by technological innovation. However trends are in place that point to the rise of personal service as being the new old thing. As a market factor, that bodes well for the synergies inherent to downtown areas and lifestyle centers, both of which also happen to make walking enjoyable.

ray

import · February 6, 2005, 7:43am

Re: Assessing NNN credit-tenant risk - Posted by mark

Posted by mark on February 06, 2005 at 08:43:37:

Here in Arizona there are multiple drug stores on each corner…if industry consolidation occurs, your tenant may be paying for a dark building, and you will have little opportunity to re-lease as a drug store… Also consider in your analysis the probability of a 5 year hold on a new building so you keep rolling out of the properties before they lose the value of the lease itself. MF